The Discount Rate: How Much Should the Government Charge in Interest

Banks lend money at interest rates that incorporate the risk of nonpayment, the rate of inflation, and a decent rate of return on investment. In contrast, government borrowing carries a low risk of nonpayment. Consequently, to convert values of future costs or benefits to present ones, governments use a different rate, most commonly called the discount rate, which depends primarily on the rate of return on investment. What constitutes a decent rate of return on investment and thus an appropriate discount rate?

Several processes come into play. First, there is the impatience principle, whereby people expect some compensation if they must wait for something.

A second process is the marginal productivity of capital, the extent to which an extra dollar invested in resources today produces more than a dollar’s worth of additional goods or services in the future. For example, if the government spends another dollar to increase the height of a hydroelectric dam, the dam should generate more than a dollar’s worth of additional electricity during its operational life.

Third, there is the opportunity cost of capital, the rate of return from potential private savings accounts or investments that might otherwise use the capital spent on a government project.

Some economists argue that the global economy has grown steadily despite dire warnings and that technological changes are likely to enable quicker, more thorough, and less expensive mitigation of global climate change in the future; therefore, a high discount rate is appropriate. Others argue that growth of the global economy has been highly dependent on the availability of cheap energy and that as we deplete readily available fossil fuels, the opportunity cost of capital will decline; therefore, the discount rate should reflect only the impatience principle and deserves a low value.

Intergenerational Equity

Most societies believe that each generation bears some responsibility for the quality of life that it leaves to its descendants and that every generation deserves an equal opportunity of success. More commonly, analysts substitute a low “social discount rate” for the real discount rate. [1] A social discount rate reflects the willingness of a society to trade present consumption of resources for the consumption of resources in the future. Nonetheless, future generations are likely to be wealthier than the present one if the world’s economy continues to grow even at modest rates. Thus, policies that sacrifice present consumption in favor of future consumption essentially transfer wealth from the poorer present generation to richer future generations, an intergenerational inequity. A positive social discount rate compensates for such inequity. Conversely, a shrinking economy such as occurred in 2008 and 2009 might justify a zero or even negative social discount rate.

Distributional Issues

Intergenerational equity treats the distribution of wealth over time. Global climate change is likely to wreak far-reaching and long-lasting shifts in resource allocations. One measure of success in resource allocation is a Pareto improvement (Vilfredo Pareto, 1848–1923, was an Italian economist) that betters the conditions of at least one individual without harming anyone else. Economic performance reaches Pareto optimality when no additional Pareto improvements are possible; that is, no other changes would make someone better off without sacrificing the well-being of someone else.However, global climate change involves nonmarket goods or services from monopolies or cartels. Supply and demand for these goods and serves fluctuate wildly and suffer from high transaction costs and large externalities. Therefore, resource allocations to remedy global climate change require a criterion other than Pareto optimality.

Kaldor-Hicks optimality (Nicholas Kaldor, 1908–1986, and John Hicks, 1904–1989, were British economists) expands Pareto optimality to include projects or regulations that will sacrifice the well-being of some people if they receive compensation for the harm they suffer.

Game theory examines situations in which certain people gain at the expense of others and where people choose their actions based on the actions of others. Nash equilibrium is the condition where no person benefits from a change in strategy if the other people keep theirs unchanged. People, when faced repeatedly with the same circumstances, become less cooperative over time and converge towards Nash equilibrium unless governmental bodies can encourage cooperation through penalties to free riders [2] (Fehr and Gachter 2000a,b). A free rider in an economic context is someone who consumes more than their fair share of a resource or fails to pay for their fair share of the costs of its production.